Tuesday, October 15, 2013

If Fama were Newton, would Shiller be Einstein?

OK OK, another quick break from my blogging break. An Econ Nobel for behavioral finance is just too juicy to resist commenting on.

Before the prize was announced, I said that it would be funny if Fama and Shiller shared the prize. But I also think it's perfectly appropriate and right that they did. Many people have called this prize self-contradictory, but I don't think that's the case at all. If Newton and Einstein had lived at the same time, and received prizes in the same year, would people say that was a contradiction? I hope not! And although it's probably true that no economist is on the same intellectual plane as those legendary physicists, Fama's Efficient Markets Hypothesis (which was actually conceived earlier, in different forms, by Bachelier and Samuelson and probably others) seems to me to be the closest thing finance has to Newton's laws, and behavioral finance - of which Shiller is one of the main inventors - seems like an update to the basic EMH theory, sort of like relativity and quantum mechanics were updates to Newton.

People criticize the Efficient Markets Hypothesis a lot, because it fails to account for a lot of the things we see in real financial markets - momentum, mean reversion, etc. But that's like criticizing Newton's laws of motion because they fail to explain atoms. Atoms are obviously important. But the fact is, Newton's laws explain a heck of a lot of stuff really well, from cannonballs to moon rockets. And the EMH explains a heck of a lot of real-world stuff really well, including:

* Why most mutual funds can't consistently beat the market without taking a lot of risk.

* Why almost all of you should invest in an index fund instead of trying to pick stocks.

These are important empirical, real-world victories for the EMH. Just like Newton's Laws will help you land on the moon, the EMH will help you make more money with less effort. I don't know what more you could ask of a scientific theory. If macroeconomics had a baseline theory as good as the EMH, it would be in much better shape than it is! (And if you think I'm being contentious by saying that, see what Gene Fama has to say about our understanding of recessions...)

Update: EMH-haters should also realize that the EMH implies that there are large market failures in the finance industry, because of the continued popularity of active management. So informational efficiency implies economic inefficiency in finance.

Anyway, sticking with the physics analogy, Shiller is really more like Michelson & Morley than Einstein. He found an anomaly - mean reversion in stock prices - that provoked a paradigm shift. In other words, Shiller really discovered behavioral finance rather than inventing it (actually, Fama, whose work is mainly empirical, isn't really like Newton either). The theorizers who came up with the reasons why markets couldn't be completely efficient were people like Joseph Stiglitz, Sanford Grossman, Paul Milgrom, and Nancy Stokey. I hope those people win Econ Nobels as well (Stiglitz, of course, already has one). But that paradigm shift built on the EMH, it didn't knock it down.

I think Mark Thoma puts it very well. The EMH is a simple model that works well in some cases, not so well in others. It's a great guide for most investors. It's not a great guide for policy, because bubbles are real, and they hurt the economy even if you can't reliably predict when they'll pop. And it's not a great guide for executive compensation, because stock prices fluctuate more than the value of firms.

But that's how science should work. You find a useful model, and then you take it as far as you can. When you hit the limits of its usefulness, you look for new stuff to add. And, by and large, that is what finance theory has done over the last half-century.

46 comments:

Thanks for a dose of sanity. There is so much derp in the finance world from traders (even a few PhD Economists) who completely misunderstand EMH. Few see the irony in their own estimates of a security's "fair value"...if markets are not efficient, there is no reason to expect prices to reflect that fair value.

What's risky is a psychological matter and varies by person -- it's a matter of what people are comfortable with. Many of the investments conventionally considered "risky" aren't risky at all, AFAICT, they're merely volatile.

A good measure of risk would correspond well to our (my?) intuitive sense of risk - not having enough money from investments when I need money from investments. Variance, the most common measure of risk, doesn't really capture this. Efforts such as Lettau & Ludvigson (e.g., http://www2.wiwi.hu-berlin.de/institute/wpol/schumpeter/lect/lettau_capm.pdf ) need more work. I haven't seen anything that captures the intuition.

BTW, Sharpe has writings that include a very similar definition of risk and a very good version of "index funds equal the average before costs."

I say EMH lacks a precise specification and you respond that there are many EMHs. I say we lack a reasonable test that would falsify EMH and you don't respond.

Fama has said we can't test EMH without an asset pricing model. I doubt a good enough asset pricing model can exist (if it did, why would market prices ever diverge).

If all EMH means is that it's hard to beat the market, then EMH doesn't say much. Lake Wobegon should be enough to convince us that most investors are not likely to beat the market (i.e., be above average).

A good measure of risk would correspond well to our (my?) intuitive sense of risk - not having enough money from investments when I need money from investments.

That makes sense to me.

say EMH lacks a precise specification and you respond that there are many EMHs.

Correct. I agree with John Cochrane that "the EMH" is a general idea and organizing principle, like "the theory of evolution". Specific hypotheses can be formulated and tested, but these require the specification of a risk measure, and as we've discussed, there are many possible specifications.

I say we lack a reasonable test that would falsify EMH and you don't respond.

I did respond! See above.

If all EMH means is that it's hard to beat the market, then EMH doesn't say much. Lake Wobegon should be enough to convince us that most investors are not likely to beat the market (i.e., be above average).

No, EMH means that you lose your ability to beat the market long, long before you become big enough to change the average itself.

Just to be clear, your answer to my objection that EMH is not testable (or falsifiable) is that there are many EMHs and a particular version would have to be specified in order for it to be tested?

If so, please suggest a specific version that is useful (or representative) and a test.

EMH means that you lose your ability to beat the market long, long before you become big enough to change the average itself.

I'm not suggesting that anything related to size. I'm saying that if a main implication of EMH is that it's hard to beat the market, then there are other ways to reach that conclusion, which should have been obvious. It is never going to be the case that most investors can beat the market, because the average investor can't beat the average, as a matter of definition (aka, the Lake Wobegone effect).

Some investors (big or small) will beat the market. This might be due to skill or luck. Statements that it is impossible to beat the market are empirically false, from an ex post facto point of view.

Just to be clear, your answer to my objection that EMH is not testable (or falsifiable) is that there are many EMHs and a particular version would have to be specified in order for it to be tested?

Yeah! You have to specify a risk measure if you want to say that expected returns are compensation for risk taken.

Keep in mind that just because you fail to reject a hypothesis doesn't mean it's right, it could just mean you have shitty data.

More importantly though, "the EMH" is more of an idea or concept than a real hypothesis. Those specific hypotheses aren't as important as the general idea. Just like "the theory of evolution".

I'm saying that if a main implication of EMH is that it's hard to beat the market, then there are other ways to reach that conclusion, which should have been obvious. It is never going to be the case that most investors can beat the market, because the average investor can't beat the average, as a matter of definition (aka, the Lake Wobegone effect).

But even with the Lake Wobegon effect, it should theoretically be possible for 50% of investors to beat the market 100% of the time. Or for 20% of investors to beat the market 80% of the time.

Most mutual funds are scams with no intent on beating the market. Even so, the primary reason they don't beat the market is fees, not stock-picking, especially in highly correlated markets, having nothing to do with EMH.

Second, owning a low cost index fund has a 100% chance of under-performing the market. A gunslinging mutual fund manager has a greater percent chance of beating the market than an index fund.

In fact, Closed End Fund NAV discounts are a hard example of EMH failing.

Regarding closed-end funds, that they normally trade for less than their NAVs is due to a combination of management fees and negative tax effects, properly taken account of most of the time. Not a violation of EMH at all.

However, these are the assets that show how full of it Fama was with his statement in the New Yorker interview that there are no bubbles. I suspect he was inaccurately stating the misspecified fundamental problem involved in studying bubbles, that it is very hard to determine the true fundamental for any asset so therefore it is very hard to declare that a price at any time is above that fundamental and hence a bubble.

But, closed-end funds are the exception in that their fundamental is their NAV minus some amount for said management fees and tax effects. Therefore, if you see a closed-end fund exhibiting a rising premium that then falls sharply, baby, this is a bubble, no two ways about it. As Barsky and DeLong put it in their JEH paper on this about the 100% premia on US closed end funds in 1929 that suddenly disappeared, one may not have been able to prove that the stock market was a bubble, but there was definitely one in the closed end fund market. We saw something similar in closed end country funds in late 1989 and early 1990. Bubbles, even if Fama thinks they do not exist. Bubble, bubble, toil and trouble.

"Most mutual funds are scams with no intent on beating the market. Even so, the primary reason they don't beat the market is fees, not stock-picking, especially in highly correlated markets, having nothing to do with EMH."

Nathanael's Law of Investment Advisors: If someone can beat the markets (and lots of people can beat the markets), then that someone will charge a fee commenserate with how much they can beat the markets by. Therefore you cannot, over time, beat the markets by hiring an advisor or mutual fund manager.

If Newton & Einstein were alive at the same time, Einstein could respond to Newton, and Newton to Einstein. And that's just what happened, since Fama's later work focused on anomalies folks like Shiller discovered. Rather than being some absurd result exposing economics as unscientific (which it still may be), Fama & Shiller (plus Hansen!) seem to be an example of economics progressing & synthesizing as a science should (and not just through the old guard dying!).

That's not how science works. You don't "add stuff" like new Ptolemaic epicycles when the model no longer fits the facts.

Sure you do.

Suppose I model a cannonball's flight as a frictionless projectile motion in a non-rotating reference frame. But then my cannon shots keep missing a little bit. So I take air resistance into account, and maybe even coriolis force. Then my cannonballs are more accurate, even though I had to make my model more complicated.

The point is, we didn't ditch Ptolemy's system because it was an inexact approximation. We ditched it because it had un-fixable flaws. Maybe someday we'll ditch the Weak EMH because we find some un-fixable flaw (and in fact I'm playing around with a couple ideas for those, and I'm sure most financial economists are as well). We already ditched the Strong EMH because it had an un-fixable flaw (information costs)...that happened way back in the early 1980s.

"Why most mutual funds can't consistently beat the market without taking a lot of risk."

The evidence looks strong that you can do much better than the market by P-E strategy, jumping out when it's very high, in when it's about average or very low. Personally, at least so far, this has worked amazingly well for me, especially all in at the bottom in 2009.

Other strategies where the evidence is good for beating the market? basically value stocks, see Haugen's "The New Finance".

And, I'm sue there are some strong cases with individual stocks. I'll have to look this up someday, but my adviser told me once of a paper which found you could get very good returns just investing on common knowledge from science journals.

And there's a lot more, but in particular, on this eve of destruction, I'm really surprised at how little the market has reacted to this default hostage crisis, and the last one. I mean it's the risk return trade-off. This is such an ugly risk. We fled for safety a month ago, and we'll just go back in when it's over -- at which time maybe there will be another reverse bubble, like in 2009! P-E rule!

It leads to another hypothesis, that not only does the market not follow the science journals that well, but they don't follow politics that intensely, and aren't that expert in it. When you have people why are really smart, and live and breathe politics and government all day long, like Jonathan Chait, Ezra Klein, and Paul Krugman really worried about default, for weeks and months, and nothing, nothing in the market until a little bit in the last week, you have to wonder -- These market people are going to know a lot more than Chait and Klein, people whose career is to do nothing but study this area, and the top ones?

They are expecting that what happened in 2011 will happen again, a last minute save by Congress and the president. Ironically, the lack of apparent crisis in the stock market, although the bond market is beginning to crazy, is probably heightening the chance of a default with Congress not feeling that much urgency to resolve the problem.

IF you do your research, you can beat the market by stock-picking. Largely because most people invested in the stock market have never seriously examined any of the individual businesses they are investing in. Some of them get valuations which are *wildly* off -- some are overpriced, others are underpriced.

This is a little trickier than looking at P/E because you're predicting future earnings, but my point is that most "analysts" are careless, short-sighted, and pay no attention to fundamentals when predicting future earnings -- so people who spend the time and effort can do better.

In a sense, this is compatible with the most interesting form of the efficient markets hypothesis:

*If* everyone had the same information and paid attention to it, *then* markets would give the "correct price" and you couldn't beat them. Markets do not give the correct price and you can beat them, *therefore* people do *not* have the same information and do *not* pay attention to the same things.

I don't see how efficient markets fails to account for momentum or mean-reversion.

1) Mean reversion. This is actually quite simple. Efficient markets don't say that expected returns should be constant. No, they could be time-varying, because they could be, for example, linked to the business cycle. In that case, mean-reversion (and predictability) is completely consistent with the EMH.

2) Momentum. Granted, this is a though one to sell. But imagine that momentum is a noisy proxy for those time-varying expected returns. Also image that expected returns, although time-varying, are relatively persistent. In that case, momentum is a noisy proxy for expected returns, which explains why winners keep winning and losers keep losing.

So inconsistent with the EMH? I'm not that sure... Could be or could not be. Who knows?

There's some staggeringly stupid nonsense from Fara (link below). He claims stimulus isn't possible. With that level of ignorance I'm baffled as to how he got his prize: or rather I'm not baffled. Various tricksters over the years have written papers that are deliberate rubbish and got them published in academic journals. So if academic journals publish any old rubbish then presumably we shouldn't be surprised if any old rubbish gets you a Nobel prize. See:

I have to say though, that in the interview Fama's criticism of macroeconomics shows a man that may have drunk a bit too much of his own medicine. In essence, he is saying that falling asset prices is a consequence rather than the cause of the recession, and by criticizing macro he is basically dodging the question of, then, what did cause the recession. I think most macroeconomists would disagree with Fama by arguing that falling asset prices had something to with it.

Having said that, I think you underestimate the importance of EMH for policy. For it raises the question that if it impossible for expert market participants to identify and profit from a bubble, the how can government officials make the right call? Are we to rely on people's hunches? Just look at the on-going debate in Australia as to whether the increase in real estate prices, similar to that in the US, reflects a bubble or not. As of yet, prices have not dropped. Without a specific definition and a model, how are we to know?

Finally, Kurt is correct that mean reversion does not necessary invalidate the EMH. It may reflect changes in the risk premium driven by changes in market risk as economic conditions improve or deteriorate.

Having said that, I think you underestimate the importance of EMH for policy. For it raises the question that if it impossible for expert market participants to identify and profit from a bubble, the how can government officials make the right call? Are we to rely on people's hunches? Just look at the on-going debate in Australia as to whether the increase in real estate prices, similar to that in the US, reflects a bubble or not. As of yet, prices have not dropped. Without a specific definition and a model, how are we to know?

Predicting the timing of asset price movements is not the same as preparing for large swings. Shiller's work shows that asset prices swing more than fundamentals. Whatever the cause of that, governments need to NOT assume that stable fundamentals mean that policymakers don't need to brace for recessions.

Finally, Kurt is correct that mean reversion does not necessary invalidate the EMH. It may reflect changes in the risk premium driven by changes in market risk as economic conditions improve or deteriorate.

Check out this post:http://johnhcochrane.blogspot.com/2013/10/bob-shillers-nobel.html

Scott Sumner also thinks falling asset prices are a result of the recession (or at least people anticipating that NGDP growth was slowing and the Fed wasn't going to respond correctly). He's a big proponent of the EMH.

"governments need to NOT assume that stable fundamentals mean that policymakers don't need to brace for recessions."

But this is a very general statement, which is to be expected from an academic. But what does this mean practically? Once again, suppose that the Australian government asked you to tell them what the high real estate prices mean, and what specific actions they need to take. What would you tell them?

So what's the point in deliberating this subject. As I understand it banks can only "change" the status of reserves from excessive to required (or push it to other bank). Both of them give the same interest rate.

Am I thinking about something in wrong way??? (Thx for the answer in advance.)

In your post blog you "answer" to Martin Feldstein that it is impossible that 0,25% IOER is holding the inflation, because that it is "too little".

But what's the point in even deliberating all that. As I understand it, BANKS CAN'T LEND OUT RESERVES. (Once again the link to the article http://www.standardandpoors.com/spf/upload/Ratings_US/Repeat_After_Me_8_14_13.pdf

is writing about "lending out" reserves. I though that this is simple banking mechanics and there are no confusions about it in economic profession, eventually this is not some theory. And banks can't lend out reserves no way!!!

And the question is: "Can banks land out reserves?" If so making loan isn't an alternative to reserve usage...

"Why "technical analysis", or chartism, doesn't work (except perhaps in the highest-frequency domains)."

Some people who use technical analysis (or just their gut instinct) make a lot of money from trading. It's not just high-frequency trading systems that are profitable.

The EMH predicts that ALL traders who make a sufficiently high number of trades will lose money, because the EMH claims that the market is a random walk, so there's a 50/50 chance whether the price will go in the direction that the trader is predicting. But traders also have to pay commission to place trades, so if the market were a random walk they actually have a less than 50% chance of winning. So if they make a high number of trades with less than 50% chance of winning there's virtually no chance that they can make a profit. And yet some people make a fortune from trading, therefore the EMH is nonsense.

Newton's theory of gravity stood for hundreds of years and it describes what actually happens in nature to a very high level of accuracy - and it's still taught in universities as if it's correct(e.g. on mechanical engineering degrees), because it is so accurate. In comparison, Fama's EMH was never right to begin with.